Investment Exchange Group

SECTION

1031EXCHANGE HANDBOOK

YOUR QUESTIONS ANSWERED

Toll free 800.908.1031 www.ixg1031.com

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Investment Exchange Group

This 1031 Exchange Handbook will simplify andclarify terminology common in the industry.

The next time you or your client asks thequestion, “Can I do a 1031 Exchange?” you willhave a quick reference guide. Title requirements,exchange wording, and explanations of reverse,construction and improvement exchanges areall covered in this handbook.

Investment Exchange Group, LLC (IXG) is anation-wide qualified intermediary specializingin all types of 1031 tax deferred exchanges. Ourteam of professional consultants will preparethe documents necessary to complete yourexchange and properly comply with currentSection 1031 tax law.

IXG maintains a $5 million fidelity bond. OurCPAs and attorneys, real estate, banking andtitle professionals offer you the protection andassurance you need to complete an exchange.

At Investment Exchange Group, we arededicated to providing you with exceptionalplanning and assistance during your exchange.

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How to determine whether yourreal estate sale could be a 1031Exchange:

1. What did you do with the property you are selling? Did you rent it out, run your business out of it, lease it, or is it raw land?As long as it is not your primary residence,it is a viable 1031 property.

2. What are you going to do with the moneyresulting from the sale? If you want to reinvest in real estate, your new propertywill most likely qualify for a 1031 Exchange.

The Questions

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The Answers1. Like-kind Property

2. The 45-day Identification Rule

3. The 180-day Rule

4. Qualified Intermediary

5. Title Requirements

6. Equal or Up Investment

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Like-kind property

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The first requirement for a 1031 Exchange isthat both the property to be sold and the newproperty be like-kind. This is one of the mostmisunderstood concepts in 1031 Exchanges.Like-kind relates to the use of the properties.Any property used to produce income qualifiesas like-kind to other income-producing property.You can sell a rental duplex to buy a ranch. Youcan sell a warehouse and buy a condo. Inaddition, raw land will always qualify for 1031treatment whether or not you had it leased.Like-kind relates to use, not the description orthe location of the property. In general, it makesno difference what the use was, as long as itwasn’t your primary residence.

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Example 1Sam and Jane own a duplex they bought in1982 and have rented out to various tenantsever since. They want to sell it and buy acondo at the beach to rent out to others anduse a little bit themselves.

> Does this qualify for a 1031 Exchange?Yes. Both properties are held for income or investment purposes.

Example 2Joe owns a barber shop business, but heonly leases the building which houses hisbusiness. He wants to retire and sell hisbusiness and buy a cabin in the mountainswith the proceeds.

> Can he do a 1031 Exchange?No. Because Joe does not own the realestate, he cannot do a 1031 Exchangeby selling his business (which is not real estate) and buying real estate to replace it.

Example 3James, a dentist, owns an office buildingthat he leases to other dentists.

> Can he exchange the building for a piece of raw land on which to build anapartment building?Yes. Investment property can always be exchanged for raw land held for income or investment purposes.

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The 45-day Identification Rule

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The Internal Revenue Code requires that youidentify your potential new (replacement) prop-erties within 45 days of the closing on the saleof the old property. The 45 days are calendardays, so if the 45th day is Sunday, Christmas,or the 4th of July, that day is still the deadlinefor identification of new properties. There areno extensions allowed. There are two ways tocomply with the 45-day identification require-ment. The first way is to have already purchasedyour new property. If you use all your moneyfrom the sale (your exchange proceeds), yourexchange is complete at that point.

In the event you haven’t closed on a new prop-erty and spent all the money within 45 days,you must identify your new property. By mid-night of the 45th day, you must compile a listof properties that you’re thinking about purchas-ing to replace the property you just sold. Thelist must be specific: it must show the propertyaddress, the legal description, or other meansof specific identification. This identification listmust be presented to your qualified intermedi-ary before the deadline.

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Notification forms and follow-up areprovided by IXG.

You can identify up to three potential newproperties without regard to their cost. Ifyou wish to identify more than threepotential replacements, however, the IRSrequires that the total value of everythingidentified be less than double the value ofthe property you sold. This is called the200% rule. You may identify more than threepossible replacements, but be aware of the200% rule.

Example 1Bev sells her old property for $100,000 onJanuary 1. She may identify up to three newproperties of any value within 45 calendardays of January 1.

Example 2Bev wants to identify four potential newproperties: four condominiums selling for$75,000 each.

> Is this ok?No. The four properties identified exceed 200% of the value of the property sold.

The 180-day Rule

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Section 1031 requires that you purchase one ormore of the new properties by the 180th dayafter the closing of the old property. You mustpurchase one or more properties listed on your45-day identification list. You cannot buy a newproperty not listed.

Example 1Brad identified a condo under constructionwithin 45 days of his sale, but now the buildertells him it won’t be completed and ready toclose within the 180 day period. If Brad cannotclose within 180 days, his exchange will fail.

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4Qualified Intermediary

The fourth requirement of Section 1031 Exchang-es is that you must use a Qualified Intermediary(QI). The QI cannot be someone with whom youhave had a business or family relationship. Thus,for example, your attorney, accountant, or broth-er are all disqualified. You must use an indepen-dent organization whose only contact with youis to serve as the QI. The QI prepares the ex-change documents, holds the cash proceedsfrom the sale, and should answer any questionsyou may have during the exchange. The QI musthold your proceeds from the sale of the propertyin order to have the transaction qualify as a1031 Exchange. If you have actual or even con-structive possession of the proceeds (i.e., con-trol of the money without actual possession),the transaction is taxable to you. If and whenyou determine that you want to undertake a1031 Exchange, you must involve the QI prior tothe closing on your sale property.

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Title Requirements

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Section 1031 requires that the taxpayer on theold property be the same taxpayer on the newproperty. Examples of entities holding propertyare trusts, corporations, partnerships and LLCs.If XYZ partnership is in title to the old property,XYZ partnership must take title to the newproperty. If you and your spouse hold title tothe old property, you and your spouse musttake title to the new property.

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Example 1Bob owns an apartment building in his ownname, but wants to buy a new property tobe held in the name of a new corporationhe wants to set up.

> Can he do this?No. He must acquire the new propertyin his own name to complete his exchange.

Example 2Pete, who is married to Margaret, owns aduplex that is titled in his name alone.

> Can he title the new property in his andMargaret’s name?No. Pete must first complete his exchange in his own name. He may then quitclaim his interest to himself and Margaret as joint tenants after theexchange is complete. In the alternative,he may take an undivided interest in the property (i.e., Pete as to anundivided 50% interest) to complete his exchange, and Margaret can take the other 50% interest. This will only work if Pete’s purchase of the 50% interest will allow him to spend all hisexchange proceeds and trade equal orup in value.

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Equal or Up Investment

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The last rule under Section 1031 is that in orderto defer 100% of the taxes on your gain on thesale of the old property, you must buy equal orup. There are two aspects of the equal or uprule. First, you must reinvest all of the cashthat is generated from the sale of the old prop-erty. Second, you have to buy a property (orproperties) that has a sale price equal to orgreater than the net sale price of the propertyyou sold. In calculating the equal or up number,there are two items to keep in mind. The firstis debt relief. The amount of money used topay off debt against the property attributableto first mortgages, second mortgages, etc. isdebt relief. The second is cash. The amount ofdebt relief, plus the amount of cash that wouldotherwise come to you as seller, is the targetreplacement value that you need to reinvest todefer 100% of the taxes.

Can you take money out of the deal at closing?Yes. This money (called boot by the IRS) istaxable, but can be taken out of the exchangewithout invalidating the rest of the exchange, ifthe exchange documentation so provides.

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Example 1.Pete owns a property he is selling for$200,000. He has a $75,000 mortgageagainst the property. He wants to buy a newproperty for $125,000 with the cash.

> Is this a fully tax deferred exchange? No. Pete is buying down from $200,000 to $125,000. Pete owes tax onthe amount of the buy down, (i.e., $75,000).

Example 2As in the example above, Pete decides tobuy a property for $250,000 by getting aloan for $150,000 and using $100,000 of the$125,000 cash the QI is holding.

> Is this exchange fully tax deferred?No. Pete did not use all the cash.

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How to Select a Qualified IntermediaryThere are no licensing requirements for QIs,and few regulations on who can serve as one.Therefore, it is crucial to select a QI withprofessional credentials and extensiveexperience.

DocumentationThe QI is responsible for putting the documen-tation in place to qualify your transaction as a1031 Exchange. That documentation must be inplace before the closing on the sale property.There are typically three documents the QI willprovide: the exchange agreement, an assign-ment, and a notice.

The exchange agreement is a contract betweenyou and the QI that sets out the rules you mustfollow in order to complete the 1031 Exchange.

The assignment of the sales contract to the QImust also be in place. This is because, theoret-ically, the Qualified Intermediary steps into yourshoes and sells the property for you. Rememberthat you cannot have control of the proceedsor the actual receipt of the money. The assign-ment allows the QI to receive the proceeds foryou.

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The third document the QI will provide is anotice to the party on the other side of thetransaction advising that the transaction isa 1031 Exchange. The purpose of notificationto the other party is to prove that the ex-change was in place at closing.

Security of FundsInsist that your QI is bonded for exchangetransactions for at least $5 million per trans-action. In addition, your QI should pay youinterest on your proceeds while the QI holdsthem.

Member of FEAVerify they are active members of the Fed-eration of Exchange Accomodators (FEA),the only national organization for QualifiedIntermediaries.

ProfessionalismExpect your QI to answer questions aboutyour exchange at no charge to you. Your QIshould have real estate, tax, and legal pro-fessionals on staff, ready and able to answereven the most complex 1031 questions. Ques-tions to ask of a prospective QI include:

Does the QI stand behind their exchanges?Ask the prospective QI if they will make yousign a hold harmless agreement that saysyou cannot sue them if they make a mistakethat results in your exchange being disal-lowed. If they require that you sign suchan agreement, and many do, find a differ-ent QI.

Does your QI provide audit protection?What happens if your exchange is audited?Section 1031 is a complicated code sectionwith many exacting and detailed require-ments. Will your QI help you navigate yourway through an audit? If so, are they willingto document their commitment in writing?Is there any cost for this audit protection?

How are the QI’s fees structured?Many QIs charge a front-end fee when yousell your old property and an additional back-end fee when you buy your new property.Some also charge an additional set-up feeand some charge a monthly holding fee. Youmay only be quoted the front-end fee whenyou inquire. Make sure you understand thetotal costs of your exchange.

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Who earns interest on the exchange funds?In most cases, it is the QI. Remember to factorthe interest earned by the money into thetransaction when you calculate the totalexchange cost. If you earn the interest, makesure that you begin to earn interest the momentyour funds hit the QI’s account.

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An Exchange TimelinePhase I:Sale of Old (Relinquished) Property

A. Contract Stage

1. Negotiate and sign your contract as seller.

2. Include language in your contract to establish your intent to do a tax deferred

exchange:“Seller intends to do a 1031 Exchange

and buyer agrees to cooperate with seller regarding the exchange at no additional cost to seller and no delayto the closing.”(The Colorado Real Estate Commissionrequires an additional form.)

3. Select a title company and/or closing agent to handle the closing of your transaction.

B. Closing Stage

1. Call IXG when you have a signed contract.Information we need:

> Phone number, name, and referencenumber for your closing agent or title company and a copy of your contract

> Your mailing address, phone and faxnumbers

> Sale price of the property you are selling

> Amount of any debt on the propertyyou are selling

> Percentage of ownership of the property you are selling (i.e., if youown half of the property)

> Whether you are going to help the buyer of your property finance the purchase (i.e., owner carry)

> In what name you hold title to the property

> If you need any cash out of the transaction (This amount will be taxable boot to you).

2. IXG will contact the closing agent or titlecompany and will prepare the exchangeagreement between you as an Exchangerand IXG.

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3. The exchange agreement will be forwarded to you or to the closing agent,depending on timing and the location ofthe closing. Draft copies of the exchangeagreement may be forwarded to you if time allows.

4. If possible, a representative of IXG will be present at closing to obtain signatureson the exchange agreement and other documents. If an IXG representative is not able to attend, the closing agent willobtain these signatures.

5. The sale closes, and funds from the saleare wired or delivered via check into yourexchange account with IXG.

Phase II:Purchase of the New (Replacement)Property

A. Identification Stage

1. You have exactly 45 days (including Sundays and holidays) from the closing

of the old property to identify up to threenew properties and 180 days to purchaseone or more of those properties.

2. From the time you decide to do an exchange, you should be looking for yournew property. If you haven’t started looking yet, you must begin earnestly seeking new properties NOW.

3. For an exchange to be 100% tax deferred,you must acquire new property that is ofequal or greater value than the old property; you must also spend all of thenet proceeds from the old property in purchasing your new property.

4. IXG will send you a notice containing the original closing date, the expirationdate of the 45-day identification period,the expiration date of the 180-day purchase closing date, confirmation of the amount we received from your closing on the old property, and a form by which you notify us of the locations ofpotential new properties.

5. You must mail or fax to IXG the property

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identification form before midnight ofthe 45th day from the closing of the old property.

B. Contract Stage

1. Negotiate and sign your contract as buyer on the new property.

2. Include language in the contract to establish your intent to do a tax deferredexchange:“Buyer intends to do a 1031 Exchange

an seller agrees to cooperate with buyer regarding the exchange at no additional cost to seller and no delayto the closing”.(The Colorado real Estate Commissionrequires an additional form.)

3. Identify a title company or closing agentto handle the closing of the transaction.

C. Closing Stage

1. Call IXG when you have a signed contractto buy. Information we need includes thephone number, name, and reference number for your closing agent or title

company, a copy of your contract andthe purchase price.

2. Let IXG know if you need an earnest money deposit from your exchangeaccount.

3. IXG will wire or deliver to closing the funds necessary to close on your purchase. IXG will contact the title company or closing agent with the necessary documents. If possible, a representative of IXG will be present atclosing to obtain signatures on docu-ments.

4. IXG’s TaXadvantage™ packet provides afinal letter and an accounting of the fundsheld, interest calculations and the 1099 IRS form required for tax purposes.

IXG makes every effort to simplify the 1031process. We complete all the necessarydocuments and tax requirements giving youthe confidence that your exchange hasbeen completed correctly. We know youwill appreciate our service. We specializein customer satisfaction.

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Advanced 1031 Issues1. Common Ownership Problems

2. Refinancing 1031 Property

3. Owner Carry Financing in 1031 Exchanges

4. Reverse Exchanges

5. Improvement Exchanges

6. Construction Exchanges

7. Reverse Construction Exchanges

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Common Ownership Problems

Any tax paying entity can do a 1031 Exchange,including C corporations, S corporations, part-nerships and limited liability companies (LLCs).Remember, the taxpayer on the old propertymust be the same taxpayer on the new property.

The most common ownership problem is thatowners often don’t know how they hold title tothe property. If two or three people own a prop-erty, they may call each other partners whilethey legally hold title to the property as tenantsin common, but file a partnership tax return toreport the income to the IRS. How they file theirtaxes is critical in the exchange.

Another common ownership problem ariseswhen an investment property is owned by anLLC or partnership. The decision has beenmade to sell the investment property, and someof the partners wish to do an exchange, whileothers wish to take the cash. In this situation,a well-intentioned attorney or CPA may advisedissolving the entity so that each owner canchoose his own course of action. However, a

Advanced 1031 Issues

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1031 Exchange requires that the taxpayerselling the old property be the entity whichcompletes the exchange by purchasing thenew property. Keep in mind that the propertymust also be held in the same name for atleast a year and a day. If the entity is dis-solved before the exchange, the IRS couldargue that the property was held for resalerather than investment, since it was heldin the partner’s individual name for only afew days from the time of the “buy” throughthe distribution, to the sale.

Ownership issues can be a real minefieldfor an exchange. Please call IXG before youenter the exchange process for individual-ized consultation.

Refinancing 1031 PropertyThere is a risk to refinancing the propertyto be sold because the IRS has ruled thatcash proceeds refinanced immediately priorto closing an exchange constitutes taxableboot. The rule of thumb in refinancing before

the exchange is: don’t. You can refinancethe newly purchased property immediatelyafter the exchange is completed.

Owner Carry Financing in1031 ExchangesIf you carry back a note on your sale property,the IRS will treat this note as taxable. Asthe payments on the note come to you, theprincipal portion of the payment is subjectto the capital gains tax, and the interestportion is subject to ordinary income tax.How can you prevent this note from beingtaxable? First, the note should be payableto the QI, which puts the note into theexchange. The note must then be convertedto cash before you can buy your newproperty. How do you turn the note intocash? There are three ways. Number oneis to get the seller of the new property toagree to take the note as part of thepurchase of the new property. As a practicalmatter, you almost never see this. Numbertwo is to find someone to buy the note.

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Unfortunately, because the note isunseasoned, (i.e., it’s a brand new note)any buyer of that note will demand a largediscount. Number three is that you, as theproperty seller, buy the note from the QIfor face value, and the QI assigns the noteback to you. Because you bought the notefrom the QI at face value, as you receive theprincipal payments, they’re tax free returnof basis to you. You will pay income tax onthe interest on the note as you receive it,but the principal payments are tax-free.Meanwhile, in your exchange account, theQI is holding cash that can now be used topurchase the new property.

Reverse ExchangesWhat if you want to buy your new propertybefore selling your old property? If you buythe new property in your name, andsubsequently sell the old property, thetransaction will not qualify as a 1031Exchange. This situation calls for a reverseexchange. In a typical reverse exchange,

the QI buys and holds (parks) the newproperty for you until you’ve closed the saleof your old property. Usually the QI sets upa new entity (call it XYZ) which will purchasethe new property for you. You provide XYZwith the funds necessary to purchase theproperty. You are also responsible for allclosing costs on the purchase, but you donot actually take title to the new property –XYZ does. Your loan to XYZ is documentedby a promissory note from XYZ to you, amortgage or deed of trust tying the moneyto the property, and an exclusive option. Theoption provides that you are the only personwho can buy the new property from XYZ.When your old property sells, the exchangeproceeds go to your QI. XYZ then transfersthe property to you and you use yourexchange proceeds to buy the new propertyfrom XYZ. This completes your 1031 ReverseExchange. From the IRS’s perspective, theexchange has not started until the oldproperty sells; it just happens that you buyyour new property from XYZ, instead of

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from the original seller. When undertakinga reverse exchange, be careful in the selec-tion of your lender. FHA and Fannie Mae-type lenders can be a problem, becausethey are being asked to lend money to you,but you will not appear on the title for ashort period of time. You should seek out abank or other portfolio lender who will makea bridge loan to you, which can then beconverted to long-term financing when XYZultimately transfers the property to you.

Improvement ExchangesAn improvement exchange allows you tobuy a fixer-upper with part of the exchangeproceeds, and use the rest of the proceedsto make improvements. In an improvementexchange, when you identify the propertyon the 45-day list, you must also specificallysay what improvements you are going tomake, and how much they will cost. Likereverse exchanges, the QI will take title tothe property while the improvements arebeing done. The QI cannot transfer the prop-erty to you until all of the improvementsare completed. You must identify sufficient

improvements to use up all your exchangeproceeds and complete the work within the180-day period.

Construction ExchangesIn a construction exchange, you buy bareland with exchange money and build a newbuilding on the land. The QI must buy theland for you and begin construction, butunlike an improvement exchange, you canclose out your exchange before the buildingis completed. You must still complete yourexchange before the 180 days are up. It’simportant to note, however, that you cannottake title to the land in your own name atthe beginning, or the exchange will be invalid.This is because you would be attempting touse part of the exchange proceeds for justthe land, and the remainder for just theimprovements, not for a completed, im-proved property.

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Reverse ConstructionExchanges

What if you can’t get enough new construc-tion completed within 180 days of your saleto equalize and finalize your exchange? Inthis case, you can do a reverse constructionexchange. Here, the QI takes title to theland with money borrowed from you beforeyou sell your old property. Construction onthe new property can begin and be wellunderway so that the construction is almostcomplete when the old property closes.

Reverse Exchange RecentDevelopments

The IRS issued a ruling (Rev. Proc. 2002-22),effective September 15, 2000, that providesa “safe harbor” in regard to Reverse Ex-changes. One of the significant points in theruling applies time limits to Reverse Ex-changes that are similar to those that hadpreviously only been applied to straightexchanges.

Provisions that must be met in order to fallwithin the safe harbor:

1. From the date of closing on the newproperty, you have 45 days to determinea list of properties you want to sell.

2. Also from the date of closing on the newproperty, you have 180 days to completethe entire reverse exchange.

3. Other properties you want to buy or sellas part of the same Reverse Exchangemust be identified.

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There are literally thousands of varia-tions of the scenarios mentioned in thishandbook. At Investment ExchangeGroup, we are glad to consult with youat any time, without charge, and answeryour questions about any aspect of 1031Exchanges. Our CPAs and attorneys, realestate, banking and title professionalsoffer you the the protection and assur-ance you need to complete an exchange.

For the Investment Exchange Groupoffice nearest you:

800.908.1031www.ixg1031.com

The Final Answer

Investment Exchange Group, LLC650 South Cherry Street, Suite 920 Denver, CO 80246

Tel 303.331.1031Toll free 800.908.1031

Fax 303.331.8448e-mail: info@ixg1031.com

www.ixg1031.com

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